In this week’s Bulletin

  • As expected the US Federal Reserve announced its intention to embark on a second round of QE to the tune of $600bn.
  • This was more than the markets expected and acted as a catalyst for a strong rally in global equity prices – many markets hit two-year highs as investors jumped aboard the Bernanke reflation express.
  • The flip-side to QE saw commodity prices also rally sharply – gold, other metals and oil all jumped to reflect the reduced buying power of the dollar.
  • A cheaper dollar might be helping US exporters but for the likes of China, Brazil and Germany it is making life difficult as their goods become less competitive.
  • Better than expected news on US employment prospects also helped buoy sentiment – 151,000 new jobs were created last month.

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Helicopter Ben
Despite the fact that the US Federal Reserve’s plan to embark on a second round of quantitative easing (known as ‘QE2’) was probably one of the central bank’s worst kept secrets, its chairman Ben Bernanke still managed to announce it to the markets with great panache. The secret of Mr Bernanke’s success was to under-promise and then over-deliver – financial markets had been primed to expect the Fed to say it would print just $500bn of new money in the coming months in order to bolster the flagging American economy. As it transpired, the Fed inflated it by 20%, meaning some 600bn of new dollars will be flowing through the system in the coming weeks and months, destined to be used to buy up medium-term-dated Treasury bonds which will help maintain the Fed’s policy of ultra-low interest rates. It’s not for nothing that Mr Bernanke, acknowledged as a leading expert on what caused the Great Depression, is colloquially known as ‘Helicopter Ben’ – in the last two years he will have inflated the Fed’s balance sheet from around $600bn to almost $3 trillion by dropping billions of new dollars into the economy and financial markets.

For some the policy is seen as highly speculative and fraught with potential – mainly inflationary – danger. Others see no alternative but to give the world’s largest economy another boost. As economist Irwin Stelzer pointed out in The Sunday Times, Mr Bernanke feels that persistent high unemployment makes this necessary and plenty of excess capacity, together with low inflation, make this economic shot-in-the-arm possible. Stelzer went on to say that, significantly, the Fed chairman says that the cash injection will support share prices “and higher stock prices will boost consumer wealth and spur spending”. To many this sounds like a re-run of the famous ‘Greenspan Put’ – the now-retired Alan Greenspan signalled to investors he would not allow the stock market to decline. The Fed’s initial announcement met with some disappointment in the bond (government debt) market because the message was that there would only be more purchases if economic conditions justified it. Specifically, the Fed said it will “adjust the program needed to best foster maximum employment and price stability”. Some economists are already looking to the next tranche, with Barclays Capital saying “the conditional linking of purchases to economic circumstances means the programme is open-ended and we believe there is a strong likelihood this figure will be exceeded”.

More Jobs Please
As previously stated, one of the primary reasons that QE2 is underway is to reduce US unemployment from its stubbornly high level of 9.6% – that’s almost 15m people who are out of work, with another 8m working part-time because they cannot find a full-time job. So Friday’s robust employment data was perfectly timed. According to official figures, non-farm payrolls showed a rise of 151,000 last month, far more than economists expected and the first increase since last May. “The report is better than expected and a most welcome development, corroborating our general thesis that the recovery is ongoing while the data suggests that worries about a double-dip recession are overblown,” commented economic group Miller Tabak. The only downside to the good news was that the overall unemployment rate remained unchanged, although observers expect that to change now the drag from changes in federal employment have finished – local governments have axed the final 1,000 of the 70,000 people temporarily employed for the US Census.

One other predictable outcome of QE was that the US dollar fell – although it rallied towards the end of the week – with the corollary that many commodity prices spiked higher as investors demanded more to compensate for the dilution of value as new dollars begin to flow. Gold hit a new all-time high of $1,395 per troy ounce as some investors feared higher inflation – made more likely as oil prices rose almost 5% on the week to almost $88 per barrel. The weak US currency is a boon for American exporters but at the same time is antagonising the country’s trading partners who have seen their competitiveness weakened. Indeed, the Organisation for Economic Co-operation and Development warned, with others, that the global economy faces an increased threat of protectionism because of tensions over exchange rates, according to The Times. On a more positive note, the OECD said economic growth would gain momentum next year and into 2012 with member state growth rising from 2.5% to 3%.

Overblown?
Worries over higher inflation are not confined to the US where it is currently muted and below the Fed’s tolerance of 2%. Here in the UK, rising prices have resulted in a higher rate of inflation than the Bank of England would like. It too has a target of 2% but the Consumer Prices Index – used by the BoE – remains elevated at 3.1% and RPI is 4.6%. Last week there were fresh concerns over a pick-up in inflation with news that the price of goods leaving Britain’s factories rose again in October. The Producer Price Index rose by 4% in the year to October, according to the Office for National Statistics, with higher petrol, food, chemical and pharmaceutical prices cited as responsible. Within the figures, the cost of food produced in the UK rose at its fastest rate for two years – up 9.8%. Some of the UK’s top retailers have warned that higher commodity prices will force up prices next year – Lord Wolfson, CEO of Next, was at the vanguard, saying higher cotton prices will add around 8% to its clothing range, which when added to the rise in VAT to 20% in January, will have a significant impact on consumers.

But is higher inflation really a problem? Well it seems that we probably need to get used to inflation remaining above the BoE’s 2% target for some while, according to Credit Suisse’s chief economist Neville Hill. “There is a good chance Mervyn King will be writing letters to the Chancellor throughout 2011. We’ve seen a big increase in food prices, some signs that retailers are front-loading the January VAT rise and there is a good chance wage inflation will pick up in the new year,” he commented. So, The Sunday Times reckons that the BoE will warn this week that inflation will remain higher than previously thought. Higher inflation, coupled with better-than-expected GDP figures last week has, said The Financial Times, reduced the probability that the Bank will restart its own QE programme for the time being.

Indeed, the pound rose strongly against a basket of leading currencies last week following an unexpected surge in manufacturing activity. The Purchasing Managers’ Index, which measures activity at British factories, showed that growth in the sector grew at its fastest since last May – the headline index rose to 54.9 from 53.5 in September – confounding economists’ expectations. And over in the jobs market, the demand for workers among British businesses rose to its highest level for a year, according to recruitment agency Reed. Demand was particularly strong in manufacturing and the marketing sectors, and accountant Deloitte said that robust profits, strong finances and tailwinds from reductions in corporation tax should help businesses cope with the impact of the £81bn government spending cuts.

Don’t Fight the Fed
That was the advice of a number of respected investment professionals last week, including Fidelity’s Tom Stevenson, writing in The Sunday Telegraph. Commenting that whilst the governments of China, Brazil and Germany may be squaring up to Ben Bernanke, equity investors in the UK and elsewhere are wisely acting on the adage of “Don’t fight the Fed”. Following the news of QE2, global stock markets, after initially hesitating, took off last Thursday with share prices rallying sharply, enabling many indices to close at levels last seen before the stomach-churning volatility of the autumn of 2008. In London, for example, the FTSE 100 index rose almost 5% on the week. Mr Stevenson thought that QE will probably work exactly as the Fed intends but also said that the danger of the central bank’s single-minded attention to solving America’s economic problems is that others will be caught in the crossfire. For example, those currencies pegged to the dollar are thus obliged to maintain expansionary monetary policies that are inappropriate for their own economies; hence the concerns being expressed by the nations attending the G20 summit in Seoul again. Mr Stevenson finished by saying that, notwithstanding, as long as the economic recovery continues, valuations remain reasonable and inflation does not spin out of control, it would be wrong to hop off Bernanke’s reflation express.

The Gangbusters
There are others who believe a second round of QE will work here too should the BoE restart it in the UK, including leading fund manager Richard Peirson of AXA Framlington.

“Although a second round of QE is less likely for now I do believe it would work this time. First time round the banks basically hung on to it but they have now addressed the balance sheet issue so therefore the next tranche would likely feed directly into the economy. I’ve found the last twelve months challenging – trying to get the right strategy has been difficult. Whilst I do have a substantial weighting of UK blue-chips, these are mainly international companies with the right ‘self-help’ attitude and that trade on low valuations.

So my equity strategy has been to avoid, for the most part, domestically biased stocks in favour of industrial companies that derive most of their earnings from outside the UK, mostly from the emerging markets. These companies have been real gangbusters – Weir Group is a perfect example. It makes valves and pumps for the infrastructure, mining, oil and nuclear sectors within emerging economies. Everything has gone right for the company – the share price has more than tripled since I first bought it and it is now a FTSE 100 constituent. I now have a little exposure to the property sector [not house builders] which has underperformed for 3–4 years – but in very niche businesses. Most of the performance has come from mid-caps and oil stocks where the portfolio is overweight in the likes of Premier Oil. High level, I do think we are on the right track for recovery but whilst I have exposure to financials such as HSBC, Standard Chartered and Lloyds the fund is not overweight and I am remaining vigilant.”

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